The Dumbest Idea In The World: Maximizing Shareholder Value

To achieve that goal, they academics argued, the company should give executives a compelling reason to place shareholder value maximization ahead of their own nest-feathering. Unfortunately, as often happens with bad ideas that make some people a lot of money, the idea caught on and has even become the conventional wisdom.

During his tenure as CEO of GE from 1981 to 2001, Jack Welch came to be seen--rightly or wrongly--as the outstanding exemplar of the theory, as a result of his capacity to grow shareholder value at GE and magically hit his numbers exactly. When Jack Welch retired from GE, the company had gone from a market value of $14 billion to $484 billion at the time of his retirement, making it, according to the stock market, the most valuable and largest company in the world. In 1999 he was named "Manager of the Century" by Fortune magazine. Since Welch retired in 2001, however, GE’s stock price has not fared so well: GE has lost around 60 percent of the market capitalization that Welch “created”.

Before 1976, professional managers were in charge of performance in the real market and were paid for performance in that real market. That is, they were in charge of earning real profits for their company and they were typically paid a base salary and bonus for meeting real market performance targets.

The change had the opposite effect from what was intended

The proponents of shareholder value maximization and stock-based executive compensation hoped that their theories would focus executives on improving the real performance of their companies and thus increasing shareholder value over time. Yet, precisely the opposite occurred. In the period of shareholder capitalism since 1976, executive compensation has exploded while corporate performance has declined.

"Maximizing shareholder value" turned out to be the disease of which it purported to be the cure. Between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990 , CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.

Meanwhile real performance was declining. From 1933 to 1976, real compound annual return on the S&P 500 was 7.5 percent. Since 1976, Martin writes, the total real return on the S&P 500 was 6.5 percent (compound annual). The situation is even starker if we look at the rate of return on assets, or the rate of return on invested capital, which according to a comprehensive study by Deloitte's Center For The Edge are today only one quarter of what they were in 1965.

Although Jack Welch was seen during his tenure as CEO of GE as the heroic exemplar of maximizing shareholder value, he came to be one of its strongest critics. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy... your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.”

The shift to delighting the customer

What to do? Given the numbers of the people and the amount of money involved, rescuing capitalism from these catastrophically bad habits won’t be easy. For most organizations, it will take a phase change. It means rethinking the very basis of a corporation and the way business is conducted, as well as the values of an entire society.

“We must shift the focus of companies back to the customer and away from shareholder value,” says Martin. “The shift necessitates a fundamental change in our prevailing theory of the firm... The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.”

If you take care of customers, writes Martin, shareholders will be drawn along for a very nice ride. The opposite is simply not true: if you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either. In the real market, there is opportunity to build for the long run rather than to exploit short-term opportunities, so the real market has a chance to produce sustainability. The real market produces meaning and motivation for organizations. The organization can create bonds with customers, imagine great plans, and bring them to fruition.

"The expectations market," says Martin, "generates little meaning. It is all about gaining advantage over a trading partner or putting two trading partners together, then tolling them for the service. This structure breeds a kind of amorality in which information is withheld or manipulated and trading partners are treated as vehicles from which to extract money in the short run, at whatever the cost to the relationship."

By contrast, the real market contributes to a sense of authenticity for individuals. Because individuals can find meaning in their jobs. They are not playing a zero-sum game. They are doing something real and positive for society.

Examples of the shift

Martin cites three examples of firms that are, even within the legal limits of today’s world, focused on the real world of customers and products more than gaming the stock market.

One is Johnson & Johnson [JNJ]. In 1982, when the Tylenol poisonings occurred, “J&J was in a terrible bind. Tylenol represented almost a fifth of the company’s profits, and any decline in its market share would be difficult to reclaim, especially in the face of rampant fear and rumor. Yet, rather than attempt to downplay the crisis—it was after all, likely the work of an individual madman in one tiny part of the country—J&J did just the opposite. Chairman James Burke immediately ordered a halt to all Tylenol production and advertising, distributed warnings to hospitals across the country, and within a week of the first death, announced a nationwide recall of every single bottle of Tylenol on the market. J&J went on to develop tamper-proof packaging for its products; an innovation that would soon become the industry standard.” Burke’s actions were not the heroic act of a single individual, says Martin. The actions flowed from the company credo which is engraved in granite at the entry to company headquarters, which makes crystal clear that customers are first, then employees, and shareholders absolutely last. Martin contrasts J&J’s handling of the Tylenol crisis with the handling of the Deepwater Horizon oil spill in 2010 by BP [BP], which he sees as driven by a short-term concern for BP’s profits.

A second example is Procter & Gamble [PG] which “declares in its purpose statement: ‘We will provide branded products and services of superior quality and value that improve the lives of the world’s consumers, now and for generations to come. As a result, consumers will reward us with leadership sales, profit and value creation, allowing our people, our shareholders and the communities in which we live and work to prosper.’ For P&G, consumers come first and shareholder value naturally follows. Per the statement of purpose, if P&G gets things right for consumers, shareholders will be rewarded as a result.”